Module 5

1. Module 5 Reporting and Analyzing Operating Assets

2. Cash • The cash account is the first asset listed in the current asset section of the balance sheet. • It consists of coin, checks, and bank drafts received by the company.

3. Helpful Tip • Transpositions occur when you switch the place of numbers (e.g., 79 becomes 97, 157 becomes 517, 6794 becomes 7649, 16945 becomes 61954) • A simple trick can identify this as the reason things do not reconcile

4. Cash Reporting • The only reporting issues for cash is whether there are restrictions on its use • Escrow • Compensating Balances

5. Proper Management of Cash • Proper management requires that enough cash be available to meet the needs of the company’s operations. • Too much cash is undesirable as it loses purchasing power in periods of inflation.

6. Accounts Receivable • When companies sell to other companies, they offer credit terms, which are called sales on credit (or credit sales or sales on account). • An example of a common credit term is 2/10, net 30. • Why offer a discount for early payment?

7. Accounts Receivable • Accounts receivable are reported on the balance sheet of the seller at net realizable value, which is the net amount the seller expects to collect. • Gross amount less an allowance for uncollectable accounts • Sellers realize that they will not be able to collect on all of the accounts that are owed to them and they must therefore match this bad debt expense with the sales revenue. • Is it optimal to have no bad debts?

8. Allowance for Uncollectible Accounts • There are two widely accepted methods to estimate the amount of accounts receivable that will not be collected: • Aging schedule • Percentage of sales • A third method, direct write-offs, is not allowable per GAAP

9. Aging Schedule • When aging the accounts, an analysis is prepared of the receivables as of the balance sheet date. • Each customer’s account balance is categorized by the number of days or months the underlying invoices have remained outstanding. • Based on prior experience or on other available statistics, bad debts percentages are applied to each of these categorized amounts, with larger percentages being applied to older accounts.

10. Aging Analysis Example

11. Write-off of Uncollectible Accounts • The write-off of an uncollecitble account does not affect income. The amount written-off is reflected as a reduction of the account receivable balance and the allowance for uncollectible accounts:

12. Reporting Accounts Receivable • Accounts receivable are reported on the balance sheet at net realizable value, that is, the gross amount owed to them less the allowance for uncollectible accounts. • Given our gross balance of $100,000 and estimated uncollectible accounts of $2,900, accounts receivable will be reported as follows:

13. Bad Debt Expense • Bad Debt Expense is equal to the increase in the allowance for uncollectible accounts. • In our previous example, if no previous balance existed in the allowance for uncollectible accounts, the company would record a bad debt expense of $2,900. • If the allowance for uncollectible accounts has a prior balance of $1,500, bad debt expense would be $1,400 (the increase in the allowance for uncollectible accounts)

14. Analysis Implications: Adequacy of Allowance Account • Companies are making two representations by reporting the accounts receivable (net) in the current asset section of the balance sheet: • They expect to collect the total amount reported on the balance sheet (remember, accounts receivable are reported net of the allowance for uncollectible accounts), and • They expect to collect this amount within the next year (because of the classification as a current asset).

15. Analysis Implications: Adequacy of Allowance Account • The first issue, from an analysis viewpoint, is whether the company has adequately provisioned for its uncollectible accounts. If not, the amount of cash ultimately collected will be less that the company is reporting. • To assess the adequacy of the allowance account: • Compare with the percentage the company reported in prior years. • Compare with the percentage reported by other companies in its industry.

16. Income Shifting • Be aware that companies have previously used the allowance for uncollectible accounts to shift income from one year into another. • For example, by underestimating the provision, expense is reduced in the income statement, thus increasing current period income.

17. Receivables Turnover Rate and Days Sales in Receivables • The accounts receivables turnover (ART) rate is defined as • The accounts receivable turnover rate reveals how many times receivables have turned (been collected) during the period. • More turns indicate that receivables are being collected quickly • A companion ratio is the Average Collection Period:

18. Insights from accounts receivable turnover • Quality Changes in turnover rates (and corresponding days outstanding) can yield insights into accounts receivable quality. If turnover slows (days outstanding lengthen) compared with prior history, industry averages, and the credit terms offered, the reason could be deterioration in collectibility of receivables. Of course, before such an inference is reached, one must consider a number of alternative explanations: • The company might have changed its credit policies for customers. • The company might have changed its sales mix to longer paying customers. • The company might have changed its estimation of the provision.

19. Inventory Issues • What is inventory? • What costs are included in inventory? • How do we separate COGS from End. Inv?

20. Inventories • The cost of inventories is reported on the balance sheet and reflects the price of goods purchased from other companies or the costs to manufacture those goods if internally produced. • Costs will vary over time and for changes in market conditions. • Consequently, the goods available for sale will likely vary in cost from one period to the next—even if the quantity of goods available remains the same.

21. Inventories • Inventory costs either are reported on the balance sheet or they are transferred to the income statement as an expense (cost of goods sold) to match against sales revenues. • The process for which costs are removed from the balance sheet is important.

22. Capitalization Costs • “Capitalization” means that a cost is recorded on the balance sheet and is not immediately expensed on the income statement. • Once costs are capitalized, they remain on the balance sheet as assets until they are used up, at which time they are transferred from the balance sheet to the income statement as expense. • If costs are capitalized rather than expensed, then assets, current income, and current equity are all greater.

23. Cost Capitalization • For purchased inventories (such as with merchandisers), the amount of cost capitalized is the purchase price. • For manufacturers, the capitalization issue is more difficult. • Manufacturing costs consist of three components: • Raw materials • Direct labor • Manufacturing overhead (all manufacturing costs except raw materials and direct labor)

24. Cost of Goods Sold • When inventories are used up in production or are sold, their cost is transferred from the balance sheet to the income statement as cost of goods sold (COGS). COGS is then matched against sales revenue to yield gross profit: Sales revenue - COGS Gross profit

25. The Cost of Goods Sold Computation

26. Inventory Cost Flows to Financial Statements

27. Effects of errors • Common source of manipulation • Often difficult for the auditor to catch • Affects two years • Example

28. Inventory Costing Methods • First-In. First-Out (FIFO). This method assumes that the first units purchased are the first units sold. • Last-In, First-Out (LIFO). The LIFO inventory costing method assumes that the last units purchased are the first to be sold. • Average cost. The average cost method assumes that the units are sold without regard to the order in which they are purchased. Instead, it computes COGS and ending inventories as a simple weighted average. • Specific identification. Uniquely identified items.

30. Inventory Costing Effects on Cash Flows • One reason frequently cited for using LIFO is the reduced tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO for tax purposes also use it for financial reporting. This is the LIFO conformity rule. • Companies using LIFO are also required to disclose the amount at which inventories would have been reported had it used FIFO. The difference between these two amounts is called the LIFO reserve.

31. CAT’s LIFO Reserve

32. Impairment of Inventories • Companies are required to write down the carrying amount of inventories on the balance sheet if, at the statement date, the reported cost exceeds their market value (determined as the current replacement cost). • This is called reporting inventories at the lower of cost or market. • Inventory book value is written down to market value. • Inventory write-down is reflected as an expense (part of cost of goods sold) on the income statement.

33. Gross profit analysis • Gross profit ratio equals gross profit divided by sales. This is an important ratio and is frequently monitored by company management and external equity analysts alike. • The gross profit ratio is frequently used instead of the dollar amount of gross profit as it allows for comparisons across companies. • A decline in this ratio is usually cause for concern since it indicates that the company has less ability to mark up the cost of its products into selling prices.

34. Possible Causes for a Decline in Gross Profit Ratio • Some possible reasons for a decline in Gross Profit Ratio follow: • Product line is stale. Perhaps it is out of fashion and the company has had to resort to “markdowns” to reduce overstocked inventories. Or, perhaps the product lines have lost their technological edge and are no longer in demand. • New competitors enter the market. Since there are now substitutes available from competitors, increased selling prices is less likely. • General decline in economic activity. This could reduce demand for its products. The recession of the early 2000s resulted in reduced gross profits for many companies. • Inventory is overstocked. If a company produces too many goods and finds itself in an overstock position, it can reduce selling prices to move inventory.

35. Inventory Turnover Rates for Selected Companies

36. Long-Term Assets • Long-term assets mainly consist of property, plant, and equipment (PPE). • These assets often makeup the largest asset amounts. • Future expenses arising from these long-term assets often makeup the larger expense amounts—typically reflected in depreciation expense and asset write-downs.

37. Capitalization of Costs • An expenditure is only reflected on the balance sheet as an asset if it possesses two characteristics: • It is owned or controlled by the entity, and • It provides future expected benefits. • Companies can only capitalize costs for which the associated cash inflows are directly linked. • The amount of costs that can be reported as an asset is limited to an amount no greater than the expected future cash inflows from the investment.

38. What is Included in Cost? • All expenditures necessary to make asset ready for its intended use. • Self constructed assets: • All construction costs (materials, direct labor, overhead). • Capital asset acquired for other than cash: • Record at fair market value (FMV) of consideration given or received. • Basket purchase: • Allocate cost based on FMV of acquired assets.

39. Postacquisition Expenditures:Betterments or Maintenance? • Betterments: • Increase asset’s useful life • Improve quality of asset’s output • Increase quantity of asset’s output • Reduce asset’s operating costs • Accounting treatment • Betterments are capitalized • Maintenance expenditures are expensed

40. Capitalizing vs. Expensing • The qualification that only those costs for which the associated cash inflows are directly linked is an important one. • The following costs are typically expensed: • Research & Development (R&D) • Advertising Costs • Employee Wages

41. Depreciation Factors and Process Depreciation requires the following estimates: • Useful life – period of time over which the asset is expected to generate cash inflows • Salvage value – Expected disposal amount for the asset at the end of its useful life • Depreciation rate – an estimate of how the asset will be used up over its useful life.

42. Depreciation Rate Assumptions • The asset is used up by the same amount each period • The asset is used up more in the early years of its useful life • The asset is used up in proportion to its actual usage

43. Variance in Depreciation • A company can depreciate different assets using different depreciation rates (and different useful lives). • Whatever depreciation rate is chosen, however, it must generally be used throughout the useful life of that asset. • Changes to depreciation rates can be made, but they must be justified as providing “better quality” financial reports.

44. Depreciation Methods • All depreciation methods have the following general formula: • Depreciation Methods: • Straight-line method • Accelerated Methods (Double-declining-balance method)

45. Straight-line Method • Straight-line method: Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset. • Consider the following example An asset (machine) with the following details: (1) cost of $100,000 (2) salvage value of $10,000 (3) useful life of 5 years

46. Straight-line Depreciation Example • For the straight-line method, we use our illustrative asset to assign the following amounts to the depreciation formula:

47. SL Example • For the asset’s first year of usage, $18,000 ($90,000 * 20%) of depreciation expense is reported in the income statement. At the end of that first year the asset is reported on the balance sheet as follows: Net book value (NBV) is cost less accumulated depreciation. • At the end of year 2, the net book value will be reduced by another $18,000 to $64,000.

48. Double-declining-balance method • Double-declining-balance method. For the double-declining-balance (DDB) method, we use our illustrative asset to assign the following amounts to the depreciation formula:

49. Double-declining-balance method • The asset is reported on the balance sheet as follows: • In the second year, $24,000 ($60,000  40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

50. DDB Depreciation Schedule